Today in the published opinion of Zak v. Chelsea Therapeutics International, the Fourth Circuit vacated the district court’s dismissal of the plaintiffs’ claim that the defendants, Chelsea Therapeutics International, LTD (“Chelsea”) and several corporate officers, violated § 10(b) of the Securities Exchange Act of 1934 (“the Exchange Act”) and remanded the case for further proceedings.

The plaintiffs in this class-action suit claim that Chelsea and several of its corporate officers violated § 10(b) of the Exchange Act, 15 U.S.C. § 78j(b), by making materially misleading statements and omissions about the development and likelihood of regulatory approval for a new drug, Northera. The district court dismissed the complaint, holding that the plaintiff’s allegations were insufficient as a matter of law to establish that the defendants acted with the requisite state of mind.

On appeal, plaintiffs contend that the district court committed two errors: (1) the district court’s consideration of exhibits submitted with defendants’ motion to dismiss and (2) the court’s determination that the plaintiffs’ allegations of scienter were legally insufficient.

Misleading Statements Regarding Northera’s Chances for FDA Approval

Northera was designed to treat symptomatic neurogenic orthostatic hypotension, a condition which may cause a dramatic drop in blood pressure when a person stands. During clinical testing, Northera’s efficacy was brought into question—only one study achieved a positive outcome. Following a December 2010 meeting with the FDA where Chelsea was warned that a single positive study typically was not sufficient to support approval of a new drug, Chelsea announced to investors that the FDA had “agreed” that Chelsea’s application for Northera could be submitted based on data from the one successful trial.

During a conference call with Chelsea investors, Chelsea President and Chief Executive Officer along with Chelsea’s Vice President and Chief Medical Officer indicated that the meeting with the FDA represented a “successful outcome” and that Chelsea was “very pleased” with the FDA’s responses to Chelsea’s questions about its application and supporting data. Following these statements, Chelsea’s stock price rose about 28%.

After submitting the drug for approval, Chelsea announced to the public on February 13, 2012 that the FDA’s briefing document indicated questions regarding the drugs efficacy in clinical trials, but it did not disclose that the FDA recommended the drug not be approved. Following the press release, Chelsea’s stock price dropped 37.5%. When the briefing document became public eight days later, Chelsea’s stock price dropped an additional 21%. The FDA made its final decision not to approve Northera on March 28, 2012, and one week later the plaintiffs filed suit.

Defendant’s Motion to Dismiss

Defendants, in their motion to dismiss, attached three documents filed with the Securities and Exchange Commission (“SEC”). One document, a “Definitive Proxy Statement,” listed the amount of Chelsea stock shares held by the company’s officers at the end of February 2012, near the end of the class period. However, it did not reflect whether any of these stock holdings had been acquired or sold during the class period. Defendants represented that none of the Chelsea officers had sold any shares of Chelsea stock during the class period and this fact undermined any inference of scienter. The plaintiffs objected to the court’s consideration of the SEC documents because they did not show whether any individuals purchased or sold stock during the period in question. At the conclusion of the hearing, the district court took judicial notice of the SEC documents, and granted the defendants’ motion to dismiss.

Fourth Circuit Review

The Fourth Circuit reviewed the district court’s dismissal de novo. The court noted that Rule 10b-5 prohibited the making of “any untrue statement of a material fact” or the omitting of “a material fact necessary in order to make the statements made . . . not misleading.” Rule 10b-5(b). Plaintiffs asserting a claim under Rule 10b-5 must establish: “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.” Yates v. Mun. Mortg. & Equity, LLC, 774 F.3d 874, 884 (4th Cir. 2014). To demonstrate scienter, a plaintiff must show that the defendant acted with “a mental state embracing intent to deceive, manipulate, or defraud.” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 319 (2007). Allegations of reckless conduct can satisfy the level of scienter necessary to survive a motion to dismiss. However, the court noted, claims of securities fraud are subject to a heightened pleading standard under the Private Securities Litigation Reform Act. 15 U.S.C. § 78u-4(b)(2).

Regarding the plaintiffs’ assertion regarding the district court’s first error, the Fourth Circuit addressed the fact that, generally, when considering a Rule 12(b)(6) dismissal, courts are limited to considering the sufficiency of the allegations set forth in the complaint and documents attached to the complaint. Because the SEC documents were not explicitly referenced in the plaintiffs’ complaint, the Fourth Circuit believed that the district court should not have considered those documents in reviewing the sufficiency of the plaintiffs’ allegations. Even if the judge had the right to take judicial notice of the documents, he did not have the right to construe it in favor the defendants. The court concluded that the district court’s consideration of the challenged SEC documents was not harmless.

The plaintiffs further asserted that the district court erred in concluding that their allegations of scienter were insufficient as a matter of law. The plaintiffs pointed out that Chelsea was aware of the FDA’s adverse recommendation regarding the approval of Northera, but withheld that information, indicating a strong inference of wrongful intent. The Fourth Circuit pronounced that the defendants’ failure to reveal such information must be viewed in the context of the statements that they affirmatively elected to make. In light of Chelsea’s failure to reveal to investors the FDA’s expectation that Northera needed at least two successful clinical trials to be considered for approval, the Fourth Circuit believed that their affirmative assertions regarding their optimism following the FDA meeting could be construed as misleading. Therefore, the court concluded that the plaintiffs’ allegations were sufficient to support the required inference of scienter.

Vacated and Remanded

Thus, the Fourth Circuit held that the district court erred in taking judicial notice of the challenged documents filed with the SEC, because the documents did not relate to the complaint. This error was not harmless. The court also held that defendants’ failure to disclose critical information about the weaknesses of the new drug application were sufficient to support a strong inference of scienter. The Fourth Circuit thus vacated the district court’s judgment and remanded the case for further proceedings.

One of the defendants, MuniMae, was one of the nation’s largest syndicators of low-income housing tax credits (“LIHTCs”). Federal tax law provides LIHTCs to developers of low-income rental housing. MuniMae organized LIHTC investment partnerships (“LIHTC Funds”) to pool and sell the credits to investors. In 2003, the Financial Accounting Standards Board adopted Interpretation No. 46R (“FIN 46R”), which defined a new category of entities—Variable Interest Entities (“VIEs”). Under FIN 46R, “a company must consolidate onto its financial statements the assets and liabilities of a VIE if the company is its ‘primary beneficiary,’ that is, if the company absorbs the majority of the risks and rewards associated with the VIE.” MuniMae began reporting compliance with FIN 46R in the first quarter of 2004.

In September of 2006, MuniMae announced that it was restating its financial statements for fiscal years 2003 through 2005, and for the first quarter of 2006. MuniMae revealed that this restatement would address accounting errors with respect to FIN 46R, and that the Company would “be required to consolidate substantially all of the low income housing tax credit equity funds it has interests in.” In a conference call in January of 2008, MuniMae provided details to its investors regarding the restatement. With respect to FIN 46R, the Company disclosed that it had to consolidate 230 LIHTC Funds, which required it to review 6,000 separate financial statements. MuniMae had no automated process in place to review the accounting, so the work had to be done manually, which required a great amount of time and effort to fix the accounting mistakes. The price of MuniMae shares dropped an additional 22.416%, to $7.13 per share. MuniMae disclosed that it spent $54.1 million to complete the restatement.

Shareholders filed multiple lawsuits against MuniMae, alleging violations of federal securities laws. The district court dismissed the plaintiffs’ Exchange Act claims, holding that the complaint did not adequately plead scienter.

Under § 10(b) of the Exchange Act, a plaintiff must prove six elements: “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.” To establish the scienter element, a plaintiff must prove that the defendant acted with “a mental state embracing intent to deceive, manipulate, or defraud.” At the pleading stage, it is sufficient to allege either intentional or severely reckless conduct. In the § 10(b) context, a reckless act is one that is “so highly unreasonable and such an extreme departure from the standard of ordinary care as to present a danger of misleading the plaintiff to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.”

The Private Securities Litigation Reform Act (“PSLRA”) imposes a heightened pleading standard on fraud allegations in private securities complaints. “[T]o the extent a plaintiff alleges corporate fraud, the plaintiff must allege facts that support a strong inference of scienter with respect to at least one authorized agent of the corporation.”

The Fourth Circuit agreed with the district court, holding that the allegations did not support a strong inference of wrongful intent. The Court acknowledged that the allegations permitted an inference that MuniMae knew that the Company was not in compliance with FIN 46R, and knew, or at least suspected, that consolidating the LIHTC Funds in accordance wit FIN 46R would be a difficult and costly undertaking. Nevertheless, the allegations did not support a strong inference of wrongful intent. The plaintiffs set forth evidence that MuniMae’s officers and an outside auditor debated how to account for the LIHTC Funds in light of FIN 46R. However, the Court held that such evidence “does not compel an inference of wrongful intent.” The Court noted that a more plausible inference is that there was an honest disagreement over the proper application of this challenging new accounting standard. This was not enough to support an inference of scienter.

The Court viewed MuniMae’s subsequent disclosures to its investors as negating an inference of fraudulent intent. The Court noted that MuniMae “(1) announced the hiring of an independent consultant to assist with the work of the second restatement, (2) identified the large number of personnel working on the accounting issues, and (3) expressed uncertainty as to the costs of the effort going forward.” This, in the Court’s view, gave rise to a more compelling inference that MuniMae was attempting “to keep the investing public informed, while working strenuously to correct the accounting errors they had discovered.” As such, the Court held that the scienter requirement was not sufficiently pled, and affirmed the district court’s dismissal of the claim.